3. How would you judge whether a firm is likely to face revenue recognition problems? Revenue recognition issues are the subjects of headlines in our daily newspapers, primarily because major corporations have recognized revenues that did not meet its revenue recognition rule. For businesses that use cash basis accounting, revenue recognition is a simple process; a sale equals revenue, but not for companies that use accrual basis accounting.
The more complex the business, the more specialized the industry, the more difficult the decision becomes for that business as to when to recognize earnings. Revenue recognition is one of the areas where managers can exercise their accounting discretion to achieve certain objectives. By looking at some potential red flags we can see if the company has a revenue recognition problem. One of the red flags at Lucent Technologies, Inc. s unusual decrease in accounts receivable in relation to sales decrease. During 2000 fiscal year revenue decreased from $10, 256 to $8,713 to $4,939 in a second, third, and fourth quarters respectively (Exhibit 4 – Consolidated Income Statement) compared to accounts receivables which also decreased but at a much slower pace from $10,573 to $10,101 to $9,558 in a second, third, and fourth quarters respectively in the same fiscal year (Exhibit 4 – Consolidated Balance Sheet).This shows that Lucent was “channel stuffing” its distribution channels to record the revenue is earlier periods than they would otherwise be recorded in.
We can see this when Lucent recognized revenue on the sale of system that had not been completely shipped and have to lower their revenue by $28 million in the forth quarter of 2000 according to the case “Revenue recognition problems in the communication equipment industry”. Second red flag is increase in inventory in relation to decrease in sales.Decline in sales while a build-up in inventory is an indication that the demand for the firm’s product is slowing down, suggesting that the firm may cut prices to get rid of excess of inventory or inventory that is becoming obsolete as well as maintain its share of the market, all of which could result in a lower profit margins. Lucent’s revenue for the second, third, and fourth quarters respectively are $10, 256 to $8,713 to $4,939 (Exhibit 4 – Consolidated Income Statement) and inventory in the same quarters are $5,321, $4,936, and $5,677 (Exhibit 4 – Consolidated Balance Sheet).Due to rapid growth in the communication equipment industry from technological advances and intense competition according to the case Lucent failed to foresee the sudden switch to fiber-optic network and lost a their share of market to their competitors such as Nortel Networks, Inc. Third red flag is unexplained transactions that boost profits. A treatment of sale of medium- to long-term financing guarantees, which Lucent made to its customers, to financial institutions is one of them.
While this arrangement may have sound business logic, it gave the management an ability to keep these loans of the balance sheet and understated its liabilities thus overstating its equity. Meanwhile, the company continued to extend credit to customers, according to the case $1. 6 billion extension of credit was finalized in agreement with a customer in addition to $1. 8 that was already extended. Thus increasing accounts receivable that reflects on allowance for bad debt that the company underestimated and had to increase it by $252 million in the last quarter of 2000.Looking at the financial statements and the disclosers, we can see if the company is likely to face revenue recognition problems. Some of the problems may come from poor management and miscommunication between the department, which might not be discovered right away, some may come from management bias and distortions.
In either case the company will have to go through revenue recognition adjustments and restatements to reflect true economics of a company.